End of the road for closed-end equity funds

Closed-end equity funds appear to be sunsetting for the third time. After making a comeback twice in the last three decades (see graph 'Number of equity fund launches in the last three decades'), they seem to again be teetering on the brink of collapse. While 2019 is yet to see the launch of a new closed-end equity fund, the evolving business dynamics following the recent regulatory changes seem to weigh heavily on these funds.

Nevertheless, their demise shouldn't hurt investors. Closed-end funds are inferior to their open-end counterparts in almost every respect. Their biggest shortcoming is that one can invest in them only in a lump sum during their NFO (new fund offer) period and there is no room for the time-tested systematic method of investing. Further, lack of liquidity is also a concern with regard to these funds.

Contrarily, the liquidity offered by open-end funds puts greater responsibility on fund managers to do their job prudently. The risk of large-scale redemptions in the case of sustained underperformance keeps fund managers on their toes. But the same does not hold true for closed-end funds.

The main argument put forth in favour of closed-end equity funds is that with no redemption pressure, a fund manager is able to build a portfolio of stocks with a long-term view and therefore deliver better results. However, a comparison of the performance numbers of both types does not reflect this fact. The graph titled 'Performance of open- vs closed-end multi-cap funds' shows the rankings of multi-cap funds based on their calendar-year returns, with top-ranked ones at the top of the bars. The graph indicates that closed-end funds have not had any clear advantage over open-end ones in terms of performance.

Despite all these flaws and no apparent advantage, why do closed-end funds keep coming back in vogue? Here's an account of their chequered past and what drove their rise and fall over the last three decades.

Early 1990s: Start of the open era
Until the early 1990s, closed-end funds were the only option available. Despite their sub-optimal structure, they played a critical role in paving the way for small investors to participate in stock markets, which was otherwise almost impossible to access at that time.

In 1993, the entry of private players in the mutual fund business marked the beginning of the dominance of open-end funds. Their superior attributes and greater transparency helped them completely take over the closed-end variants by the turn of the century.

2006-2008: The second innings
Although they never became mainstream after the 1990s, closed-end equity funds revived in 2006 after SEBI banned the practice of charging initial issue expenses on open-end funds. For the uninitiated, mutual funds in those days were allowed to charge as much as 6 per cent of the money raised during their launch as 'initial issue expenses' to pay hefty commissions to distributors. However, SEBI banned this practice for open-end funds but not for closed-end ones.

As a result, mutual funds started launching closed-end funds so that they could continue paying heavy commissions to distributors to drive sales. Therefore, what was supposed to be an investor-friendly move by the regulator ironically worked to the detriment of investors. Closed-end equity funds died a second death in 2008 when SEBI plugged this regulatory loophole by banning the initial issue expenses on these funds as well.

2013-2018: The final nail
After a four-year hiatus, the tide again turned in favour of closed-end funds in 2013, a time when fund companies were facing a difficult business environment. The abolition of entry loads (in 2009), combined with a low investor interest because of the stagnant markets, made raising new money challenging. But closed-end funds were still a better bet as fund companies could pay upfront commissions out of their own pocket and subsequently recover it from investors while their money was locked in. As a result, there was a spike in the number of closed-end fund launches.

Cut to 2018, a bunch of regulatory changes pushed closed-end funds into a black hole. SEBI capped the total expense ratio (TER) of closed-end equity funds at 1.25 per cent, half of what their open-end cousins can charge. Its impact was drastic. According to a study by Value Research, the expense ratios of closed-end funds have fallen by 40 per cent since this ruling came into effect. Moreover, the regulator has disallowed fund companies from paying upfront commissions to the distributors altogether, even from their own pocket.

The combined effect of these measures is that there's no incentive left for AMCs or distributors to hawk closed-end equity funds. The trends in recent quarters reveal (see graph 'Rapid decline of close-ended equity funds') how rapidly fund houses have bid adieu to these funds following the announcement of the new rules in 2018.

Conclusion
Quite understandably, business considerations, not investor interest, have driven the popularity of closed-end equity funds. Open-end funds are certainly a better choice. The open-end structure has especially played a great role in positioning mutual funds as a regular savings vehicle for the retail masses.

Closed-end ones should have been ditched long back, but they now appear to have finally met their fate. This is hardly surprising.